An Argument for Targeting Asset Prices

Money supply data from the US and (EZ and UK) all point to similar states of beingâ€¦banks are not creating credit, their primary function. Because solvency concerns (yes way down from late-2008) remain a key consideration, banks are hoarding cash (excess reserves held at central banks). However, banks are not stasis entities. They are using their balance sheets to fund government deficits borrowing at record low rates overnight and lending at much higher rates by buying â€śrisk freeâ€ťassets or government debt. Banks are also using their balance sheets to reach for yield, buying corporate debt, emerging market sovereign and corporate debt and lending freely to non-bank financials (real and leveraged accounts) who are asset accumulators as well.

So there is a duality of risk in play in the banking systemâ€¦one that shies away from households and many firms (good credits get lumped in with bad credits yielding no credit) and another that is attracted to risk assets as banks seek to maximize income in areas not related to traditional lending. In some respects this is a barbell approach to risk in the banking systemâ€¦one channel that supports asset prices and another that depresses, or at the very least does not support, activity in the private sector. Indeed risk metrics for banks look quite reasonable â€“ low on consumer and firm lending, high on prime brokerage, trading and cash management yields reasonable net risk.

From a policy perspective at a central bank, there can only be a desire to support this approach (with policy) to ending the Great Recession if one believes in a very powerful wealth effectâ€¦higher asset prices yield greater household wealth yielding greater consumption. Unfortunately, the current arrangement in the banking system is not lifting the key asset where most household wealth restsâ€¦real estate. And then there is very mixed evidence on how powerful the wealth effect is and surely with the HELOC market pretty well shutdown, the home ATM machine is not likely to generate a new round a private demand even if home prices were rising (IMHO home prices are going into a second important down leg).

Stocks from March 2009 lows had scope to rise because another depression was avoided and the world of capitalism did not end. But I humbly believe that stock prices 60% above the 2009 lows and rising are not warranted based on the very flat private sector economic activity in most places outside of the BRICs. Monetary (and fiscal) accommodation are leading to a new asset bubble in equities and corporate debt unless you believe in a Jack Welch V-shaped recovery (his assertion on CNBC Wednesday which failed to recognize that growth from the biggest crash in GDP in 75 years is relative).

Yes we are in a liquidity trap in terms of the normal transmission mechanism of monetary policy â€“ bank lending does not pick up with the fall in rates. But the unintended (I think) consequence is a get out of trap free card for equities and other risk assets as the money put into the banking system flows in part into riskier assets either directly through the banks or indirectly through non-bank financial firms. This is a very different outcome than Japanâ€™s lost decade and ZIRPâ€¦money flowed into JGBs, but not risk assetsâ€¦Nikkei went nowhere. Maybe that has something to do with a very undeveloped non-bank financial system in Japan.

If the Fed is pushing on a string on bank lending, it is pushing on a stick with asset prices which without a recovery in private demand is unsustainable and will see stocks and risk assets reach the next edge of the next precipice and go Wylie Coyote again.

So I think the Fed has to move earlier on withdrawing liquidity from the banking system to prevent a crash in the stock market and risk assets ahead, even before the real economy does much to close the output gap. If zero cost of funds at near unlimited amounts is not helping generate credit creation and private sector activity, then pulling it back now in a gradual way will not do much to change this condition. It should stop the bubble forming in asset markets however and prevent the next shock from happening. The Fed need not raise rates anytime soon, but complacency over leaving banks flush with cash is untenable if you believe the rally in stocks is based on much more than ubiquitous, cheap money available only to banks and near banks.

David Gilmore

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